Solvency Ratios
In our earlier posts we have discussed Profitability Ratios and Liquidity Ratios. The capacity of the business to meet its short-term and long term obligations can be generalized into the term “Solvencyâ€. Creditors, bank loans and bills payable etc come under the inclusion of Short Term obligations. Long-term obligations broadly encompass – debenture, long-term loans and long-term creditors etc. Solvency Ratios are an indication of the financial soundness of a business to continue the operations of its business smoothly, without any impediments and meet its all obligations. Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the concern have already been explained. Now under this part of the chapter only the long-term solvency ratios are dealt with. Some of the important ratios which are given below in order to determine the solvency of the concerned:
Debt – Equity Ratio
Proprietary Ratio
Capital Gearing Ratio
Debt Service Ratio or Interest Coverage Ratio
1. Debt – Equity Ratio
This ratio is designed to ascertain the firm’s obligations to creditors in relation to funds invested by
the owners. It is an indication of all external liabilities to owner’s recorded claims.
Debt – Equity Ratio = Total Long Term Debts / Shareholders Fund |
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2. Proprietary Ratio
Proprietary Ratio is also termed as Capital Ratio or Net Worth to Total Asset Ratio. It serves as one
of the variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth. The relationship
between shareholders’ fund and total assets is formed by this ratio.
Proprietary Ratio = Shareholders Fund/ Total Assets |
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3. Capital Gearing Ratio
This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term
capital gearing refers to describe the relationship between fixed interest and/or fixed dividend
bearing securities and the equity shareholders’ fund.
Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds |
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4. Debt Service Ratio or Interest Coverage Ratio
Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed Charges Cover Ratio. This ratio
denotes the equation between the amount of net profit before deduction of interest and tax and
the fixed interest charges. It is used as a yardstick for the lenders to gain an insight that the business
concern will be able to pay its interest periodically.
Debt Service Ratio or Interest Coverage Ratio = Net profit before Interest & Taxes / Fixed Interest Charges |
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5. OVER ALL PROFITABILITY RATIOS
The overall profitability of a firm on the extent of operating efficiency it enjoys. This ratio establishes
the relationship between profitability on sales and the profitability on investment turnover.
Overall Profitability Ratio = Net Profit / Total Assets |
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The lower a company’s solvency ratio, the greater the probability that it will default on its debt
obligations.
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